External Obsolescence?

[Lisa Fetzer]

I am completing the cost approach for a newly constructed single family home in a PUD. The foreclosure rate in this area is well above 50% of houses of similar condition and quality and an over supply issue (1/1/2008-today: LOTS: 80 listings/3 sales, SFR: 158 listings/25 sales).

THE APPRAISAL OF REAL ESTATE Twelfth Edition, Chapter 14: The Cost Approach , pg. 363 states ”External obsolescence-- a temporary or permanent impairment of the utility or salability due to negative influences outside the property. (External obsolescence may result from adverse market conditions. Because of its fixed location, real estate is subject to external influences that usually cannot be controlled by the home owner, landlord or tenant.)”

When is it appropriate to use external obsolescence for market conditions?

 

[Michigan CG]

Lisa, let's take your subject. Let's assume a Cost New of $200,000. It is relatively new but let's say you have 5% physical depreciation from minor wear and tear. Then you have functional obsolescence, which in a newer home will be next to nil, but let us again say 5%. So we have a depreciated value of $180,000 before we take into account external (economic) obsolescence.

The sales comparison approach points to a value of $150,000. The missing $30,000 obsolescence is from somewhere outside of the property itself, therefore external or economic, whatever you want to call it.

externalities
1. The principle that economies outside a property have a positive effect on its value while diseconomies outside a property have a negative effect upon its value.
2. Costs or benefits accruing to a property for which compensation or remuneration cannot be handled through normal, contractual procedures.

external obsolescence
An element of depreciation; a defect, usually incurable, caused by negative influences outside a site and generally incurable on the part of the owner, landlord, or tenant.

economic depreciation
A decline in the economy that negatively impacts real estate values.


Maybe the people who built this home should have thought about this:

economic feasibility
The ability of a project or an enterprise to meet defined investment objectives; an invest-ment's ability to produce sufficient revenue to pay all expenses and charges and to provide a reasonable return on and recapture of the money invested. In reference to a service or residential property where revenue is not a fundamental consideration, economic soundness is based on the need for and desirability of the property for a particular purpose. An investment property is economically feasible if its prospective earning power is sufficient to pay a fair rate of return on its complete cost (including indirect costs), i.e., the estimated value at completion equals or exceeds the estimated cost.

 

[hastalavista]

When is it appropriate to use external obsolescence for market conditions?

That is an excellent question! :new_smile-l:
(and as Tim says, external can be economic. I think the new text and courses are leaning toward calling all depreciation just "depreciation").

It seems the only time one would consider using it is when one has a situation Tim described at the beginning of his post. And I think his example is a correct one.
The problem (not Tim's, but the cost approach's) is an economic depreciation adjustment kinda looks like a fudge-factor to make the cost approach fit to the sales comparison approach, doesn't it?

If you follow Tim's example, you will be following the examples in the recognized texts.

Good luck!

 

[ETex2]

That is an excellent question! :new_smile-l:
(and as Tim says, external can be economic. I think the new text and courses are leaning toward calling all depreciation just "depreciation").

It seems the only time one would consider using it is when one has a situation Tim described at the beginning of his post. And I think his example is a correct one.
The problem (not Tim's, but the cost approach's) is an economic depreciation adjustment kinda looks like a fudge-factor to make the cost approach fit to the sales comparison approach, doesn't it?

If you follow Tim's example, you will be following the examples in the recognized texts.

Good luck!

That's what obsolescence is all about. If your cost approach is a lot higher than the other two approaches, it's the definitive "equalizer". And appropriately so.

In the late '80s and early '90s, every single income property we were appraising had some measure of economic or external obsolescence, since it generally wasn't feasible to build it in that market. Sometimes the value adjustment was close to 50%. It's a test of financial feasibility in the highest and best use.

 

[Mztk1]

Cost is defined as either:

1. The outlay of expenditure to produce a product, or
2. The amount charged for something.

Most believe we are doing the first with the cost approach, but we are really doing the second.

Our cost approach is a compilation of the separate charges (or charges on a per square foot basis) a market builder will charge the typical buyer in a given market.

In effect, we are doing a price to produce in the cost approach, not the builder's expense to produce.

In all prices there are mark ups. Our price per square foot and estimates to build decks, porches, etc., are no different. That market, in a soft market, will decline over time. The decline in the market of cost pricing is the economic depreciation of a given market.

The difficulty is in separating how much is coming from a reduction in the charge to build vs the value of the land. The only way to determine it is through land sales. If you have very good land sale data relevant to the subject lot, it is easy.

If you have land sales but none very relevant to the subject, statistical analysis is an option, finding how much of the drop in value for a given market is related to land can be accomplished by analyzinge year over year stats for land, and compare those values to the year over year value change for similar lots that were sold improved.

As an example I did one the other day. Vacant sales dropped from $90,000 to $72,000 on average over the past year, or 20%. The improved properties on those same type lots dropped on average from $240,000 to $218,000. Knowing raw land dropped $18,000 and improved properties dropped in total by $22,000, I realized there was a 2.5% reduction in the builders pricing, which I applied to the cost approach as a form of economic depreciation.

I've seen higher. I did one that was $30,000 today. But it is not fudging. It is actually something that does happen and should be measured when possible. Unfortunately, it is not always measurable.

 

[hastalavista]

That's what obsolescence is all about. If your cost approach is a lot higher than the other two approaches, it's the definitive "equalizer". And appropriately so.

Then my cost approach, if higher, should always match my sales comparison approach once I apply the appropriate "equalizer"?

It's a test of financial feasibility in the highest and best use.

I agree with you here.
But the cost approach is supposed to be an independent approach to value. How independent (and how good a validation tool) is it if my adjustment of first resort when costs exceed SCA indicated value is to apply an equalizer (make it equal to)?

 

[incognito]

(and as Tim says, external can be economic.

They are the same animal.....

In answer to the original posters question: Always!

A better way to quantify external (old school) or economic (new school) obsolexcence may be to take a look at your income approach, as well.

 

[ETex2]

Then my cost approach, if higher, should always match my sales comparison approach once I apply the appropriate "equalizer"?


I agree with you here.
But the cost approach is supposed to be an independent approach to value. How independent (and how good a validation tool) is it if my adjustment of first resort when costs exceed SCA indicated value is to apply an equalizer (make it equal to)?

Not necessarily. But if you have 2 approaches that are close but well below the cost approach, what did you do wrong? Are you saying that EO is not appropriate?

 

[Mztk1]

But the cost approach is supposed to be an independent approach to value. How independent (and how good a validation tool) is it if my adjustment of first resort when costs exceed SCA indicated value is to apply an equalizer (make it equal to)?

The cost approach is a market approach. The price a builder charges to build is market driven. If the market is unwilling to pay the price, the builder can take less of a profit, pay his people less, hire less experienced people, or cut costs of his own elsewhere. In order to find these shifts in the builder's market you have to look to the sales.

 

[hastalavista]

Are you saying that EO is not appropriate?

Not at all. It is totally appropriate.
It is totally appropriate because without it, the CA value isn't supported in the market.
And if the CA isn't supported in the market unless an adjustment based on the SCA is applied to it, what does that say about the reliability of the CA as an independent valuation analysis?
To me, it says this:
Well, it works when they are close. But when they are not, we equalize the CA to the SCA and then they are close and it works.

You made the point that the Cost Approach makes a good feasibility study- again I agree. Much smarter members than I on this forum have made similar arguments (although when used for a feasibility study, they do not call it a "cost approach". Just a feasibility study).

No, Steve, don't get me wrong. My argument isn't so much with the points you are making (they are the same ones in the courses and texts). My argument is with the CA itself as a reliable and independent approach to value.

But, I was forced to consider it today.
I had very good land comps and spoke to two land brokers to verify the land values and trends. I had InsureBASE cost estimates and a contractor estimate that was unrelated to my subject. They were very close. I could have been a little off on the "as is" value of the site improvements and certainly on the depreciation. Every developer I have spoken to in these markets gives me the same profit target: 18-23% before they go into a project.

My SCA value: About $1,500k+/-
The CA value: About $1,800k+/-

I'm fairly certain those costs are pretty accurate. So, what gives on the CA's estimate?
EI- should I have used 10% rather than 20%? If I did, not too many developers will take the risk on a project like this if that is their expected pay-out.
Other than finding an equalizer based on the SCA, where else would one obtain an adjustment to reconcile the difference (no income approach on this assignment). And, why is the bias in a case like this not that the SCA is too low, but that the Cost Approach is too high and needs to be adjusted down?

What my cost approach analysis did tell me, Steve, is what you suggest: As a developer, I would choose not to build at this time based on those economics.
But it doesn't tell me what the property is worth.... unless I go to the SCA and equalize it. :new_smile-l: